How Manufacturers and Distributors Set Electronic Component Prices

Have you ever heard large Electronics Manufacturing Services (EMS) companies have a price advantage because they buy in high volume? This misconception, usually perpetuated by large EMS companies, suggests that their size and scale automatically translate into better pricing for you. 

However, the reality of how electronic component pricing works is far more complex and nuanced. In fact, relying solely on your EMS partner to manage component costs can be a risky approach—no top-tier OEM (Original Equipment Manufacturer) lets their EMS suppliers control component prices.

So, if the size of your EMS supplier isn't the key determinant of prices, what is? The answer may surprise–it's you. 

How Distribution Works

Before diving into the specifics of pricing, it's essential to understand the distribution landscape for electronic components. Distributors fall into two broad categories: "authorized" and "unauthorized." Unauthorized distributors, often referred to as brokers or the gray market, operate outside the official channels. On the other hand, authorized distributors—such as Avnet and Arrow—have formal contracts with manufacturers (like Texas Instruments or Microchip), granting the distributors specific privileges that are crucial for managing inventory and pricing.

Two privileges distinguish authorized distribution from the gray market:

1. Stock Rotation: This allows distributors to return slow-moving inventory to manufacturers, helping them manage stock levels more effectively. In recent years manufacturers have been restricting this privilege, making it less and less valuable.
2. Ship from Stock and Debit System (Debit): This is the most important privilege and is central to understanding how component pricing is controlled and adjusted. Let's focus on how this works.

The Three Types of Electronic Component Pricing

There are three primary pricing types for electronic components: Book Price, Broken Price, and Direct Price. Each plays a different role in the procurement process.

1. Book Price

The Book Price is what you typically see listed on distributor websites and Octopart. It is usually tiered based on purchase volume—for example, pricing might be broken down into ranges such as 1-50 units, 50-100 units, and so on. This price is usually a suggested retail price published by the component manufacturer.

The actual price paid by the distributor to the manufacturer is referred to as the "book cost." Distributors pay the manufacturer the book cost and hold it in their inventory at book cost.

The listed price for each distributor reflects the distributor's markup, which can vary based on several factors, but most commonly, they use the manufacturer's suggested pricing online. While manufacturers can suggest a resale price, distributors have the freedom to adjust their margins as they see fit. 

In many cases, distributors offer a preferred pricing model to specific customers, reflecting an adjusted margin still based on book cost. This is the price you see when you log into a distributor's site and view your special price.

It's important to remember the price the distributor pays to the component manufacturer is always the book cost, and the distributor owns the inventory at that cost.

2. Broken Price

The Broken Price (also called contract or special price) comes into play during competitive bids. In such cases, a manufacturer might agree to "break" the book cost that the distributor has already paid. Since the distributor holds inventory purchased at the book cost, the manufacturer will issue a "debit" to account for the lower cost, allowing the distributor to offer a more competitive price to the customer.

For instance, consider a distributor holding 1,000 units of a component with a book cost of $1.00 per unit. The online prices might range from $1.50 for small quantities to $1.30 for larger orders. If a company requests a bid for 500 units, the distributor might approach the manufacturer for a broken cost. The manufacturer may decide to issue a debit, reducing the cost of those 500 units to $0.70. The distributor would apply a margin, let's say 25%, and sell the units at a broken price of $0.93 ($0.70 / .75).

This system is called ship from stock and debit or debit for short. This debit system is integral to how production pricing is managed, and it is specific to the customer and controlled by the manufacturer. Importantly, the manufacturer is likely to offer the same broken cost to any distributor that requests it for a given opportunity, ensuring a level playing field among authorized distributors.

3. Direct Price

The Direct Price is the cost directly quoted by the manufacturer to the OEM, bypassing distributors altogether. This pricing model is employed when the manufacturer and OEM have a direct purchasing agreement, often for large-volume orders. Direct prices are very specific to a single customer, so if an EMS company buys directly, they can use that price only for that customer. The manufacturer will typically extend the same direct price to the OEM and to the EMS of the customer's choosing.

Factors Influencing Price Decisions

1. Manufacturers' Pricing Strategies

Manufacturers determine pricing based on several key factors, with decisions often made by a Product Manager responsible for a specific product segment. The three main considerations are:

• Commodity Spend: The Product Manager first assesses the customer's total available market within the relevant commodity. Higher-spending customers, particularly those with significant purchasing power in a specific segment, may be offered more competitive pricing. The manufacturer's goal is to secure business with customers that have substantial market presence or potential for long-term purchasing.
• Geographic Location: Manufacturers consider geographic regions when setting prices. Typically, they view the U.S. and Europe as low-volume, new product introduction (NPI) markets. These regions are often priced higher than high-volume production markets, such as those in Asia, where the expectation is for larger orders and sustained demand. This pricing approach reflects the manufacturer's anticipation of lower volume but higher innovation and customization needs in certain regions.
• Strategic Considerations: Strategic interests also play a crucial role in pricing decisions. Manufacturers may offer favorable pricing to marquee customers whose endorsement can enhance the product's reputation in the market. Similarly, if a manufacturer is focused on establishing a new product, they might provide discounts to early adopters or influential customers. Additionally, manufacturers may adjust pricing based on their production capacity—either incentivizing sales for products where they have excess capacity or setting higher prices for components that are in short supply.

2. Distributors' Pricing Considerations

Distributors have limited control over their costs, which are set by the manufacturer. However, they do control the profit margin they apply to these costs, and this margin is influenced by two primary factors: Market Dynamics and Relationship Value.

• Market Dynamics: The market dynamics of a given commodity set the broad range within which distributors operate. These dynamics are determined first by the overall commodity market, then by specific types of components, and finally, by individual part numbers, especially during periods of short supply.
• Relationship Value: Where within the market-defined range a distributor sets their price largely depends on the value of their relationship with the OEM or EMS provider. This is an interplay between the Distributor Total Available Market (DTAM, reflecting available market for the distributors franchised lines) and their existing relationship with the customer. For instance, if your DTAM exceeds $100,000, you're likely to attract the distributor's attention in almost any market. However, even if your DTAM is substantial—say, $1 million— but the distributor knows you favor a competitor, they may not offer their best margins.

When market availability is constrained, there is often tension between Market Dynamics and Relationship Value. While Market Dynamics might push for higher margins due to short supply, doing so can damage the Relationship Value, as raising prices in response to temporary disruptions can be seen as predatory pricing. Distributors must navigate this tension carefully to maintain strong, long-term relationships with their customers.

Caveat Emptor

This system is how most components are priced, and effectively, all EMS companies have access to the same prices; there is no absolute advantage for large EMS companies. 

But access is not the same as skill. All too often, we see small EMS companies who buy into this myth because they don't understand this system, and they inadvertently ask the wrong questions. For example, let's say an OEM approaches a small, naïve EMS company and a large, savvy one with an opportunity to build 1000 units. The naïve EMS company will seek component prices for 1000 units. The savvy EMS knows component manufacturers base their price decisions on annual volume and will ask the customer what annual usage is. If the annual usage is 12,000 per year, that is the number they will use to get pricing.

There are situations where large EMS companies will make bulk purchases and capture a lower price they can then use with any customer (a few distributors do this also). This kind of thing is very rare outside of low-cost passive components like capacitors and resistors.

But the biggest reason for "buyer beware" is that EMS companies base prices on cost plus. It is manifestly in their interest for you to believe material costs are higher than what they actually pay because it makes their profit margin look lower. 

Practical Takeaways for Procurement Professionals

Understanding the nuances of electronic component pricing is crucial for procurement professionals involved with electronic components or assemblies. Here are some key takeaways:

1. You are the most important factor in pricing: Your distribution and EMS partners are crucial to your success, but they don't control component costs. The manufacturers control component cost and they cost based on your company.
2. Don't Rely Solely on EMS Providers for Pricing: While EMS providers play a critical role in the supply chain, they may not always offer the best component prices for your specific needs. It's important to be actively involved in the procurement process and independently control component prices.
3. Leverage Geographic Location and Commodity Spend: Your location and total spend in a commodity can significantly influence pricing. Consider these factors when negotiating prices with distributors or manufacturers, especially if you have facilities in Asia.
4. Understand the Pricing Mechanisms: Familiarize yourself with how book, broken, and direct prices work. This knowledge will empower you to make more informed decisions and negotiate better deals.
5. Build Strong Relationships with Distributors: Authorized distributors have the flexibility to adjust margins based on their relationship with you. Cultivating a strong partnership will lead to more favorable pricing.

In summary, electronic component pricing is a multifaceted process influenced by various factors beyond the size of your EMS provider. By understanding the underlying mechanisms and engaging directly with distributors and manufacturers, you can optimize your procurement strategy, secure better prices for your components, and base your EMS selection on factors other than price.